June 19, 2014

The Myth of the Billion Dollar Startup

According to the Wall Street Journal, there are now as many as thirty companies who consider themselves startups valued at a billion dollars or more, based on how much money they’ve raised through private equity funding, and how much of the company they gave up to get that funding. But while the meme of “yet another billion dollar startup” is a fun one, the reality is that these are instead highly valued private companies who operate like public companies, and have the same kind of deep resources that most public companies have, but haven’t yet taken that leap to the retail trading markets - supported by changes in the venture funding process and new rules that make being a public company harder.

Often, it’s too easy to label a private company as a “startup”, no matter the number of employees working there, no matter their revenue achieved, or how many years they’ve been in business or selling product. Uber, who has raised a reported $1.6 billion dollars, and sports an $18.2 billion valuation, is not a startup. Spotify, which has raised $521 million dollars, and is valued above $4 billion, is not a startup. The same holds true for Dropbox, Jawbone, Square, GoPro and other companies that have significant market traction and name recognition, but aren’t yet traded on the open markets.

A startup embodies an idea on the way to becoming a product on the path to becoming a successful company. Startups bring to mind working with single to double digit employees, making ends meet by taking risk, putting in crazy hours, and never really having quite enough resources to relax or reduce the pace of innovation. Startups are scrappy, not luxurious.

What's Made the Billion Dollar "Startup" Possible and Desired

What’s happened is that these companies have found ways to gain fast access to high amounts of capital, without needing to give up the majority of their company, and without needing to go public. And that’s largely due to two major developments that have changed the industry since I started working in Silicon Valley more than fifteen years ago.

The first major development was the introduction of the Sarbanes-Oxley Act in 2002, which aims to protect retail investors through improved accounting and financial responsibility - setting high standards, requirements and auditing paths for public companies and those intending to soon become public. The act rose out of the companies built on vapor and lies, from Enron, Tyco, Worldcom and others, but while this was beneficial, it also added on additional headaches and costs to companies looking to graduate from private to public. Some, if they could, would prefer to stay private as long as possible, to avoid this scrutiny, as well as reporting to Wall Street every quarter, and being subject to their demands and whims.

The second big development was the rise of markets where early startup employees could sell their options before the company even went public. While in the late 1990s and early 2000s, employees would have to see their company go public to get any money out of their options, and then be subject to subsequent lockup periods, you see people leaving companies like Twitter, Facebook, and others even before the IPO date, with millions of dollars in their pockets, through transactions on Second Market and the rise of funds like Lower Case Capital, who make those options real, by exchanging real money for options.

The combination of those two elements reduces the demand from inside the company to go public - both from the restless employees and from the busy management. And you see the change in the way these companies now raise money. Instead of a small seed round, followed by an A round, companies raise millions in the seed round, and skip that step. Instead of a Mezzanine round followed by an IPO, companies will sometimes raise the hundreds of millions they would previously have gotten through IPO in a private round that extends their runway even further. You can see that with Sunrun raising $150 million in a single round, which included $100 million from an unnamed public investor, or Uber’s latest $1.2 billion round.

If going public is a pain, and the benefits of going public aren’t there, then why go? So they don’t. Companies get funded and grow even larger, employees get rich and can cash out their shares, and when the company eventually does decide to file and place their shares on the NASDAQ or NYSE, instead of the big pop and sustained rise you used to see, retail investors find the big multiple increases have already taken place in the private markets, and the existing investors are the ones who get the lion’s share of the reward.

Prior to joining Google, I spent 8 ½ years at the venture funded BlueArc, a network storage company which took in more than a quarter billion dollars in funding over its lifespan before being acquired by Hitachi Data Systems in 2011 (two years after I had left). When we raised $72 million in May of 2001, and were valued at more than $300 million, we hadn’t yet shipped a single unit for revenue. But you needed nearly $100 million to get off the ground in the hardware space - and that continues with companies like Pure Storage, who just raised $225 million at a 3 billion valuation in April. BlueArc may have been like a startup in 2001, but by 2004 and 2007 or so, when we were years into selling, had hundreds of customers and multiple product generations, we weren’t a startup. Just a private company that happened to be highly valued.

So let’s recognize the world has changed a bit over the last two decades and call them for what they are. These aren’t startups - and most of the upside from investing in these companies comes before they even go public, not after the fact. The companies are disincentivized to be on the public market, and their employees, in many cases, are already getting the rewards that others of us could only dream of. We’ve got to come up with new terms and for emerging companies and tell them to check their startup credentials at the door.

Disclosures: I used to work at BlueArc for 8 ½ years. I am a customer of SunRun and love their products. I work at Google, which you could assume competes with DropBox, Twitter and Facebook in some ways, and yes, some of my friends at Google Ventures are investors in Uber, but I have no bias in favor or against the company as a result.